Will Free-Marketeers Save Fannie and Freddie?: Phillip L. Swagel

By Phillip L. Swagel -
Jul 18, 2011

Here is one clear lesson from the
economic meltdown of 2008: Any future U.S. administration will
intervene directly and heavily if faced with a potentially
devastating economic crisis. Market purists might not like it,
but it is a fact I witnessed firsthand at the Treasury
Department during the George W. Bush administration.

As a corollary, it is also true that the government will be
compelled to step in if it becomes concerned that American
families cannot obtain mortgages at reasonable interest rates.
Indeed, it is inevitable that the government will also intervene
if secondary mortgage markets -- that is, the trade in
securities and bonds made up of bundled mortgages -- lock up.

The math is simple: Home mortgages represent $10 trillion
out of $53 trillion in total U.S. credit market debt; remember
that the Treasury and Federal Reserve felt compelled to
stabilize money-market mutual funds in the fall of 2008 when
they held just under $4 trillion.

Acknowledging these facts is central to solving a problem
Congress is finally taking seriously: deciding the future of the
government-sponsored enterprises at the center of the housing
collapse, Fannie Mae and Freddie Mac.

Members of Congress, who began debating several bills to
reform Fannie and Freddie last week, must start from this
implicit promise of government intervention. Thus it makes
little sense for Republicans to push for an ideal, purely
market-based system. That head-in-the-sand approach will only
help those like Representative George Miller, Democrat of
California, who call for increasing government involvement.

Instead of holding out for an unattainable goal,
conservatives would be wise to move forward with housing reform
that specifies an explicit, but limited, government role.

The centerpiece of any proposal should be protecting
taxpayers. The best way to make that happen is to bring private
capital back into the market and ensure that it would take
losses ahead of any government guarantee on mortgages and
securities composed of them.

Fortunately, Congress already has a good model to follow: a
bipartisan proposal now before the House sponsored by John Campbell, a California Republican, and Gary Peters, Democrat of
Michigan. Under the plan, at least five private firms would be
set up to finance and securitize high-quality conventional
mortgages. The government would guarantee the resulting
financial instruments, but the companies would have to pay
insurance premiums for that backstop. The firms themselves would
not be guaranteed -- only the mortgage-backed securities they
created would be protected.

Such a program would create a competitive market in which
Fannie and Freddie would become just two of many firms involved
in securitization, and neither would be too important to fail.
Over time they would probably be sold back into private hands or
wound down.

Critics will no doubt make the case that Fannie and Freddie
made housing possible for the less affluent, who would be left
behind in a freer system. Under such a proposal, a portion of
the insurance premiums could be earmarked for affordable-housing
initiatives.

More important, an open market is also the best way to spur
useful innovation in mortgages, as lenders would compete to find
ways to help credit-worthy borrowers with modest incomes become
owners. An irony is that the large banks so many Americans blame
for the economic crisis are the companies most likely to compete
effectively with Fannie and Freddie. (Disclosure: I have done
consulting work for some large banks on reforming those
enterprises.)

In order to give all competitors equal footing, regulators
should require all firms involved to issue standardized
mortgage-backed securities, as opposed to the current system in
which Fannie’s and Freddie’s securities trade separately from
other mortgage-backed instruments. This would have side-
benefits: unifying the market would improve mortgage liquidity
and thus probably lower interest rates for borrowers.

There are a few caveats. There is a risk in having the
government price insurance -- something that it has done a
terrible job at with flood insurance, for example. But any price
it charges will be better than zero, which was the de facto rate
in the Fannie-Freddie system that was ostensibly private but had
its implicit federal guarantee.

The larger concern is what would happen to interest rates
as the government backstop receded. If private investors
overwhelmingly balked at taking on housing risk, it could lead
to a surge in interest rates and further depress home sales and
construction. Thus the prudent path would be to go quickly to a
competitive system but phase out the current federal role at a
slower pace, namely by gradually bringing in private capital
ahead of a secondary government guarantee.

The longer Fannie and Freddie stay in government hands, the
more likely they will become permanent wards of the state. This
would be the worst of possibilities, yet it becomes more likely
as conservatives push for a supposedly private housing financing
system that has no hope of enactment. The government will always
be part of the housing market; let’s make sure we keep its role
as small and contained as possible.

(Phillip L. Swagel is a professor at the University of
Maryland School of Public Policy. He was assistant secretary for
economic policy at the Treasury Department from December 2006 to
January 2009.)